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12/2018

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Cause and Consequence

Pascal Blackburne & Luc Synaeghel2018-12-07

Photograph: Alexander Nemenov/AFP/Getty Images

Have financial markets been correcting because of underlying weakness in the real economy? Or could it be that market turmoil will be what bring this long-lasting economic upcycle to its knees? As we turn the last page of 2018, the eternal “chicken or egg” question is very much open.

President Trump’s (admittedly small) loss in the US midterm elections – which he himself of course termed a victory – will undoubtedly limit his domestic powers. Over the next two years, Democrats will do all they can, short of an impeachment procedure for which they do not have the votes and that might actually backfire, to make his tenure more complicated. In view of the Attorney General’s ousting and replacement by a Trump “ally” just one day after the elections, the new House majority will notably ensure that the Mueller investigation on President Trump’s relation with Russia proceeds and its results are made public (an objective that most Republicans, deep-down, probably share). More than ever, thus, external affairs will be where the US President has the greatest latitude.

What then to make of his attitude at the just-held G20 summit? For once, while not fully adhering to the final statement, he did not adopt a belligerent stance at – or just after – the meeting. And he made big positive media headlines in agreeing to a 90-day truce with the Chinese President on the trade conflict. This is typical of Trump’s business-like approach to running the country: any decision amounts to a bargaining position, usually with a specific timeframe attached to it. Unfortunately, in our view, trade is far too complex an issue to be resolved in 3 months – if the negotiations are even allowed to go on that long. For another of Trump’s characteristics is his propensity to brusquely change his mind. Our take on trade continues to be that, while fighting an important war against China, the US has drawn the wrong weapons and should have built an allied front rather than going it alone. Meanwhile, and not to be detracted by short-term US sanctions and gesticulations, the Chinese are securing access to key mineral resources and are hard at work building their new Silk Road.

The other major takeaway from the G20 summit was the warm greeting given by Russia’s Putin to Saudi Arabia’s currently very disreputable crown prince – with the added message that the OPEC+ coalition led by the two countries will act shortly to reduce production again. Note that on this issue too, President Trump’s unpredictability has played an important part. At first, he sought higher oil prices for the benefit of US shale producers. Later, wanting to sanction Iran but avoid too strong an oil price, he pressed Saudi Arabia to boost production in order to offset the pending loss in Iranian exports. And then, he granted (6-month!) exemptions to all buyers of Iranian oil that requested them, causing supply to outpace demand – and the price to drop sharply.

What is sure looking to 2019 is that financial markets will continue to have to deal with (not to say fear) an impulsive and unpredictable US President, meaning that volatility is here to stay, and investors will demand a higher risk premium. This despite a global economic backdrop that, while slowing, still seems solid – unless policy uncertainty were also to undermine business confidence.

Not the time to give up on oil

Let us return for a moment to the dynamics of oil, in an attempt to understand its violent and rapid price decline. Early October, WTI crude was trading just above USD 75 per barrel – up some 25% since the start of the year. It has since retraced all of its 2018 gains, and more, ending November around USD 50. Has OPEC+, as has come to be known the cooperation initiated in late 2016 between OPEC member countries (led by world number 3 producer: Saudi Arabia) and Russia (world number 2 producer), lost control of the situation? We believe not. Rather, it is the shifting and inconsistent US stance on Iranian sanctions, combined with the weight of short-term speculators in the spot oil market, which caused this sharp correction.

Saudi Arabia cannot be too happy right now with the attitude of its long-term US “friend”. Following President Trump’s announcement that sanctions on Iranian production were to be reinstated, it dutifully complied with US requests to boost production, so as to make up for the Iranian barrels that were to be lost – and hence avoid further pressuring an already tight oil supply-demand balance. Little did it know that the US Administration would then liberally afford exemptions to countries wanting to buy Iranian oil. Saudi Arabia thus finds itself in a situation where its efforts of the past couple of years to support the oil price appear vain – and the stock market debuts of Aramco (its national oil company) ever more elusive.

As for the impact of speculators, remember that the oil spot price pertains to the marginal barrel, the vast majority of the 100 million barrels traded daily being sold at a fixed price through longer-term contracts. Traders in the spot market, hedge funds notably, have a very short-term horizon and are almost solely focused on US oil inventories, whose recent expansion they consider an indicator of worrisome oversupply. As such, in our humble opinion, they are basing their investment decisions on incomplete and temporary figures. Needless to say, fears of an escalation of the US-China trade conflict also contributed to nervous short-term trading over the past few weeks.

But with the global economy still posting healthy growth, crude should make a rapid price comeback when the recent “accidental” oversupply situation (to the order of 1 million barrels per day, i.e. only 1%) is reversed. As part of the just concluded trade truce, China indicated that it will resume imports of US shale oil. And, as we write, OPEC+ is meeting in Vienna to agree on production cuts.

In terms of the 2019 outlook, considering fiscal breakeven levels for the different OPEC+ countries (see chart), the current oil price should prove a solid floor. On the upside, we see potential towards USD 80, which would still be less what Saudi Arabia needs to balance its budget. We thus strongly feel that now is not the time to give up on oil holdings.

And should, contrary to our expectations, crude remain weak during coming months, its longer-term case would only strengthen markedly – for lack of very necessary investments in new capacity.

What does 2019 hold in store

Beyond just oil, as we look out to the new year, our take on the global economic backdrop remains constructive. While clearly now at a mature stage of its cycle, the US economy does not appear on the verge of recession. A slowdown of growth is to be expected relative to the rapid pace of 2018, but fiscal stimulus has not yet fully played out and infrastructure investments are possible within a divided Congress. The main risk, as we have repeatedly pointed out, pertains to inflation. With higher import prices compounding wage pressures, and oil to bring only a temporary reprieve, US inflation figures are set to exceed the Federal Reserve target. US monetary policy is thus likely to continue to tighten progressively in 2019, contradicting complacent investor expectations.

In Europe, growth is also coming back down closer to trend, although the German dip appears transitory – attributable mostly to the new automobile emission standards. The European Central Bank should proceed as announced, terminating its asset purchase program this month. The Brexit and Italian budgetary situations are obviously major concerns, but disorderly developments are not our base scenario at this stage. In Italy, more specifically, we expect the government to come to an agreement with the European Commission on a 1.9% deficit, only to later under deliver on its promise (an outcome for which it cannot be sanctioned).

Notwithstanding widespread fears, China is still headed for at least 6% growth in 2019, as the effects of stimulus measures – notably a relaxation of credit restrictions – materialise. Emerging economies that sell commodities and other goods to China will feel the relief. And, at this pace, it will not be that long before the second-largest world economy catches up on the US.

Finally, the outlook for Japan is slightly more subdued, ahead of the consumption tax hike scheduled for 2019. The good news is that wage growth has finally picked up, although far from having reached a point at which the Bank of Japan would reconsider its accommodative stance.

From an investment perspective, as we wrote last month, this supportive macro picture means that there are still returns to be earned on financial assets for investors that can withstand the volatility brought about by complicated and ever-shifting geopolitics. This is not to say that we would rush to buy high-flying names on dips. Rather, we reaffirm our preference for companies that offer a combination of value (buying cheap being the first condition for investors not to lose money) and high worth, whether in the form of assets, brand name or market position. And we reiterate the importance of having a long-term horizon on these holdings.

US Recession Concerns are Premature

Pascal Blackburne & Luc Synaeghel2018-08-09

The market is wrong in thinking that the US have nothing to lose in a trade war with China – just as it is wrong in expecting the world’s largest economy to weaken already next year.

Last month, we pointed to an acceleration in US growth, courtesy of the Trump fiscal boost, suggesting that it would not only extend the cycle beyond 2019 but also have dire inflationary implications, forcing the Federal Reserve (Fed) to push interest rates up by larger increments. The first reading of 2nd quarter US real GDP buttressed this view. Overall growth came in at 4.1% (on a seasonally-adjusted and annualised basis), well above the 2.2% recorded for the 1st quarter and almost double the pace in Europe. And the speeding-up of the economy was mainly domestically-driven: personal consumption grew a strong 4.0% and business fixed investment was particularly impressive, expanding by 7.3%.

Predicting a US recession as soon as 2019, when companies are just starting to invest after a decade of post-financial crisis restraint and the infrastructure spending component of public stimulus has yet to materialise, is anathema to us. Rather, we see the US engine continuing to fire on all cylinders and expect Fed Chairman Powell to stay the course – irrespective of President Trump’s recent attempts to interfere.By incrementing its target rate by quarterly steps of 25bps, the Fed currently considers 2.9% as the equilibrium rate. We, however, think this might not be high enough to tame the American beast. Rates will rise across all maturities, driving an upward shift (but no inversion for the foreseeable future) of the yield curve and US dollar appreciation. Needless to say, higher rates will exert downward pressure on equity valuations.

The ongoing trade dispute constitutes the only threat to this sanguine 2019 view of the US economy. Just over USD 500 billion of goods were exported from China to the US in 2017, a mere 3% of Chinese GDP. Thus, even if the Trump administration were to push through with tariffs on all of those goods, the impact on the Chinese economy would be minimal. Meanwhile, potential retaliatory action by Chinese policy makers – for instance a suspension of part or all commerce with the US – would inflict severe damage to the US economy. The important point here is that China can find an alternative source for all of its imports from the US, while US companies’ value chains (notably in the IT space) are very dependent on Chinese manufacturing (Apple's IPhone is made in China).

All told, we see only two possible outcomes to the US-China trade dispute. Either the US administration backs down, realising that it is the weaker of the two opponents – and perhaps also surrendering to internal pressure from the farming, car manufacturing and IT communities. Of course, this would have to be done in a way that avoids President Trump losing face ahead of the mid-term elections. Or else the conflict turns military, with fighting in the South Chinese seas. This could occur if China were to act rashly in suspending exports to the US and the US in turn consider their national security to be endangered. It is not an outcome that we deem likely, to the extent that Chinese authorities have demonstrated time and again their patient, well thought-out and long-term approach – and ultimately know that they hold the upper hand.

Fastest US growth since 2014

It is admittedly only an “advance estimate”, but the recent 2nd quarter GDP report did confirm what we suspected: the US economy is on a tear. Real growth in excess of 4% had not been experienced since the latter part of 2014.

Moreover, the 4.1% overall growth was broad-based, with the slower pace of inventory accumulation as the only detractor (essentially offsetting the 1.1% positive contribution from net exports). Domestic final demand increased by an impressive 3.9%, driven by a 4.0% increase in personal consumption and a 7.3% pick-up in business investment.

As regards the consumer component, it is interesting to note that the official data set for the personal savings rate recently underwent considerable revision. Previously assessed at just over 3%, it is now estimated to be close to 7%, providing further fuel for consumer spending during the coming quarters.

On the corporate side, all lights (save for possible side-effects of the trade dispute on business confidence) are now green for investing in productive capacity. US earnings are strong thanks to solid sales growth and the lower corporate tax rate, spare capacity has been almost fully resorbed, and repatriated foreign profits (another benefit of tax reform) are looking for somewhere to go.

In the non-industrial space, particularly the so-called FAANG companies (Facebook, Apple, Amazon, Netflix and Alphabet’s Google), repatriated capital is no doubt being affected to share buybacks – regardless of the obvious overvaluations. This year alone, according to Goldman Sachs, share buyback plans worth over USD 1’000 billion will be announced. In doing so, these US market heavy-weights are fuelling the upward move in the indices, particularly on the NASDAQ exchange, and forcing ever-growing index funds to follow suit. That is, until the music eventually stops. Not to mention possible investigation by regulators of the apparent conflictof interest when members of management sell paper just days after their company has announced a buyback program. (Cf. link : Stock Buybacks and Corporate Cashouts)

Reflections on the US-China trade dispute

In thinking about the trade dispute, it is important to remember how large the Chinese economy has become. The country’s GDP is expected to reach USD 14 trillion in 2018, not only gradually closing in on the US (whose GDP is estimated at around USD 20 trillion) but also putting into perspective the ca. USD 500 billion of Chinese exports to the US.

That all this “fuss” effectively pertains to only 3% of Chinese GDP highlights the fact that President Trump’s crusade against China – which is supported by the US Congress, unlike other measures targeted at Europe – is occurring too late.

It is quite true that China does not playa fair game, that it has little respect for intellectual property rights and that it hinders foreign company access to the local market. But that war should have been waged many years ago, when the Chinese economy was much more dependent on exports.

Not only are the US measures striking too late, they are also not the appropriate ones. By antagonizing China with tariffs on (soon perhaps all) goods exported to the US, President Trump risks causing greater damage domestically than in China.

Beyond “tit-for-tat” tariffs (on an admittedly smaller amount of US exports to China), Chinese policy makers could attempt to disrupt US companies’ supply chains, by limiting production at partner Chinese companies or simply suspending trade with the US. The most affected sector, as illustrated in chart 2, would clearly be Information Technology, notably semiconductor and hardware companies.